Loss Aversion: How Avoiding Risk Can Increase Your Risk

Everyone likes making money. Seeing an investment go up in value is a good feeling that we all enjoy. But we truly hate losing money. Research suggests that the psychological pain that we experience from losing money is roughly twice as strong as the joy that we feel when we gain the same amount of money.

This phenomenon leads to an emotional bias known as loss aversion. In simple terms, loss aversion refers to the tendency of people to strongly prefer avoiding losses as opposed to acquiring gains. The implications of this bias can be significant, as humans’ aversion to loss is so powerful that it can actually lead to risk taking instead of risk aversion.

To illustrate this point, imagine an investor who owns a stock that has lost a significant amount of value due to deterioration in fundamentals. Future prospects for the company look poor, and there is plenty of uncertainty surrounding the business. In such a case, continuing to hold the stock is risky, as there still could be meaningful additional downside in the stock because of the company’s fundamental issues.

However, many investors who find themselves in this position continue to hold the stock, for no other reason than that selling the stock would make the loss “real” in their minds rather than just a paper loss. The prospect of having to face such a powerfully negative feeling is enough to cause many investors to actually take on more risk by continuing to hold the stock instead of simply selling the stock and moving on to better and less risky investments.

Obviously I am not advocating for investors to simply sell all their losers, as buying high and selling low is not a winning investment strategy. But when a stock’s fundamentals warrant a sale, we must make the rational decision to sell, no matter the pain we might feel as a result of realizing the loss. Failing to do so puts us at greater risk for even more losses in the future.

Interestingly, we can also observe loss aversion in situations where investors have actually experienced a gain on an investment. The prospect of seeing an unrealized gain on an investment dissipate can be so emotionally distressing that many investors will sell a winning investment too soon, completely ignoring the possibility that the company’s fundamentals may suggest additional upside.

Loss aversion is one of the strongest emotional biases that we face because of the intensity of emotion that is felt when we experience loss. Accordingly, we must be especially vigilant in identifying this bias. While it is impossible to entirely avoid the effects of loss aversion, we can try to minimize them by being intellectually honest with ourselves when an investment has gained or lost value and remaining focused on an investment’s fundamentals instead of how much money we might stand to gain or lose by selling it.

Seeking to avoid losing money is obviously a rational thing to do, so long as it helps us to avoid engaging in unnecessarily risky behavior. However, when our desire to avoid losing becomes so strong that it causes us to make incrementally riskier decisions, then it becomes an impediment to rational decision-making.

With regard to investing, fundamentals are the key to overcoming this impediment. Understanding the fundamental drivers of an investment’s value and responding to changes in those fundamentals, as well as valuations, can help us to make sound decisions that keep risk in check and help us reach our financial goals.

This information is prepared for informational purposes only and should not be considered investment advice. The views expressed are those of the author as of the date of this report, and are subject to change at any time due to changes in market or economic conditions. Investing involves risk, including loss of principal. There is no guarantee that the investment strategy discussed will outperform any other strategy in the future.